Slope Of Hope with Tim Knight

A Closer Look at the HUI vs. SPX

Let's dial in the ratio of the HUI Gold Bugs index vs. the S&P 500 that we have been reviewing from a monthly 'big picture' perspective.  This weekly chart is also a big picture, but it adds the 250 week moving average and weekly MACD, along with its slower brother, TRIX, for more definition.

People should realize that while there is significant reason for fundamental optimism about quality companies within the gold stock sector this is, on a pound for pound basis, one of the most aggressively hyped stock sectors on the planet.  The same can be said for gold itself.

Why is this?  I believe it stems from a core and righteous belief by many gold bugs that things are not right with the system (thanks Captain Obvious :-)), gold should be money again (or at least it should anchor the paper of the modern realm) and it is simply a matter of time before destiny is achieved.

Gold, while in a predictable phase of under performance due to the Euro relief and US earnings and temporary 'jobs' pumps, has been beaten back from its impulsive highs during the acute phase of the Euro crisis.  Hype took gold up, and hype is taking it down or more accurately, is causing it to under perform what is now being hyped; namely the salvation of the system as we know it and the ever present tout of conventional stocks.

Transports Vulnerable to Double-Top

Hedging Update -- ETFs

The Chicago Board Options Exchange Market Volatility Index (VIX) dropped 2.39% Thursday, to close at 15.95. The table below shows the costs, as of Thursday's close, of hedging the 20 most actively-traded ETFs against greater-than-20% declines over the next several months, using the optimal puts for that. First, a reminder about why I've used 20% as a decline threshold and what optimal puts mean in this context.

Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web, and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance academic to sort through and analyze all of the available puts for your position, scanning for the optimal ones (there's an example of this, with screen shots, in this recent article regarding the last ETF in the table below, TLT).

Decline Thresholds

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008: 

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.

How Costs Are Calculated

To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).

Hedging costs as of Thursday

The data in the table below is as of Thursday's close. The ETFs are listed in order trading volume Thursday, with the most actively-traded name (SPY) at the top.

Symbol	Name	Cost of Protection (as % of position value)
SPY	SPDR S&P 500	1.10%*
IWM	iShares Russell 2000 Index	2.25%*
EWJ	iShares MSCI Japan	1.78%*
EEM	iShares MSCI Emerging Markets	2.25%*
XLF	Financial Select Sector SPDR	1.92%*
XLI	Industrial Select Sector SPDR	1.85%*
XLE	Select Sector SPDR -- Energy	2.10%*
EFA	iShares MSCI EAFE Index	2.03%*
EWZ	iShares MSCI Brazil Index	3.86%*
USO	United States Oil	3.52%*
XLK	Technology Select Sector SPDR	1.39%*
SMH	Semiconductor HOLDRs	2.42%*
XLB	Materials Select Sector SPDR	2.66%*
EWT	iShares MSCI Taiwan Index	2.61%*
IYR	iShares Dow Jones Real Estate	1.92%*
XLU	Utilities Select Sector SPDR	0.97%*
XLY	Consumer Discretionary SPDR	1.59%*
XLV	Health Care Select SPDR	1.11%*
XLP	Consumer Staples Select SPDR	0.75%*
TLT	iShares Barclays 20+ Yr. Treas.	0.74%*

*Based on optimal puts expiring in January, 2012.

Hedging Update -- ETFs

With weak economic data and renewed risks from the Euro zone, the Chicago Board Options Exchange Market Volatility Index (VIX) ticked up again Thursday to 22.73, its highest level since March. The table below shows the costs, as of Thursday's close, of hedging 18 of the 20 most actively-traded ETFs against greater-than-20% declines over the next several months, using the optimal puts for that. First, a reminder about why I've used 20% as a decline threshold, what optimal puts mean in this context, and a quick note about why there were no optimal puts for 2 of these ETFs.

Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web, and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance academic to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.

How Costs Are Calculated

To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).

Why There Were No Optimal Puts for VXX and FAZ

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with iPath S&P 500 VIX Short-Term (VXX) and the Direxion Daily Financial Bear 3X (FAZ). As of Thursday's close, the cost of protecting against greater-than-20% declines in those stocks over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.

Hedging costs as of Thursday

The data in the table below is as of Thursday's close. The ETFs are listed in order of 125-day exponential moving average volume, with the most actively-traded name (SPY) at the top.

Symbol	Name	Cost of Protection (as % of position value)
SPY	SPDR S&P 500	1.64%*
XLF	Financial Select Sector SPDR	3.44%*
EEM	iShares MSCI Emerging Markets	2.82%*
IWM	iShares Russell 2000 Index	2.82%*
QQQ	PowerShares QQQ	2.13%*
SLV	iShares Silver Trust	7.71%**
EWJ	iShares MSCI Japan Index	3.21%*
SDS	ProShares UltraShort S&P 500	3.87%*
FAS	Direxion Daily Financial Bull 3X	No optimal puts at this threshold
XLE	Select Sector SPDR -- Energy	2.72%*
VXX	iPath S&P 500 VIX Short-Term	No optimal puts at this threshold
VWO	Vanguard Emerging Markets	3.87%*
EFA	iShares MSCI EAFE Index	3.72%*
XLI	Industrial Select Sector SPDR	2.57%*
FXI	iShares FTSE China 25 Index	2.99%**
GLD	SPDR Gold Shares	0.40%*
USO	United States Oil	4.57%**
EWZ	iShares MSCI Brazil Index	3.61%*
XLB	Materials Select Sector SPDR	3.12%*
SSO	ProShares Ultra S&P 500	7.89%*

*Based on optimal puts expiring in December, 2011.

**Based on optimal puts expiring in January, 2012.

ODP : My Favorite Long-Term Short

 Best Buy (BBY) eventually survived Circuit City and Barnes & Noble (BKS) survived Borders.

When Borders filed for Chapter 11 bankruptcy protection in February, I started thinking about the dynamic: two or three competitors, with tight (or tightening) margins, struggling for survival in a crummy economy.  Essentially, I’m looking for specific weakness and betting against whoever I think will most likely die.  

The retail office product space looks to fit well into this model.  Staples (SPLS), Office Depot (ODP) and OfficeMax (OMX) all took a severe beating in the 2008 drop. 

 
 
 
 

They survived, but performance was poor compared to the S&P. 

 

Since I have a Staples and an Office Depot in town, I actually investigated both stores.  Been to Staples a bunch of times for the usual stuff, but I was more interested in the competition.  I have one word for Office Depot: grim.  Product selection appeared significantly more limited and some of what was there was actually dusty; all with the help from a staff energized like they’re expecting either a reduction-in-force or a physical beating at any minute; so I went short ODP in March. 

If I was inclined to put on a pairs trade, it would be long Staples and short Office Depot.  Good thing I was waiting for earnings to come out before going long Staples- as of yesterday, they reported much lower-than-expected quarterly earnings and slashed its full-year forecast, sending shares in the world's largest office supplies retailer down the most in a day in 11 years and renewing talk of consolidation (Staples shares fall after profit outlook cut).  As expected, Staples got hit for -15%, OfficeMax for -7.7% and Office Depot for -5.45%.  I feel a little better putting the 2^nd half of the pairs trade on sometime over the next few weeks- at a much lower price.

Today, Oppenheimer cut its rating on Staples and OfficeMax to "perform" from "outperform," saying sales trends for office supplies retailers appear unlikely to rebound any time soon.  (Note: I think Office Depot wasn’t mentioned as they are already rated “perform” on 10/25/2010).

Technically speaking, ODP remains weak:

 

 

Over the long haul, chances are Staples will be a (the?) survivor and I see Office Depot as the weakest of the three with the greatest fundamental challenges.

Short Candidates

2 Sectors are on my early list of adequate short candidates. The way the chart is stretched looks very attractive to me. These are probably the first 2 sectors taking a dive soon and I like to be part of it.  A load the boat approach is of course wrong but a tiny position to sit on with a view of 3-4 month time frame does sound reasonable .

It is a perfect hedge for long positions of other sectors held.

 

Optimal Puts vs. Index ETFs for Hedging

Hey Fellow Slopers,

This another post that might be a little basic for some of you, but a question came up recently about the differences between hedging with inverse ETFs and optimal puts, and since I know there are some self-described beginners among Slope lurkers, I thought it would be worth an elaboration here.

Inverse ETFs can be useful tools in hedging against market, sector, or industry risk, but there are a few reasons why investors may want to consider using optimal puts to provide downside protection for their portfolios (a quick reminder: optimal puts are the ones which will give you the exact level of protection you want at the lowest possible cost):

• Ability to hedge against idiosyncratic (or, stock-specific) risk. Say you own a particular stock and you are unwilling or unable to sell some of your stake in it to reduce your downside risk. If the stock has options traded on it, you may be able to use optimal puts to hedge against a decline due to an event specific to that stock. Inverse ETFs can be used to offset market risk or industry risk, but not stock-specific risk. For example, if you owned Toreador Resources Corp. (TRGL -- a stock we mentioned in a post here last month,"Market Neutral: Short TRGL, Long IMO") at the beginning of the year, owning optimal puts on it could have limited your downside as TRGL declined since then, but owning shares of the ProShares Short Oil & Gas ETF (DDG) wouldn't have, as that inverse ETF has declined year-to-date as well, as the chart below shows. 

• Precision. Say you own 824 shares of Exxon Mobil, and you'd like to know how to hedge that position against a greater-than-17% loss. Using Portfolio Armor (available as a web app and as an Apple iOS app), you could simply enter "XOM" in the symbol field, "824" in the number of shares field, and "17%" in the threshold field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost.¹

• Ability to cap cost at the outset. It's not always clear how investors who use inverse ETFs decide how much of their portfolios to allocate to them -- I've asked Inverse ETF investors about this in the past, and in response have been told they "feel comfortable with" some small percentage. To use a round number here, let's say an investor decided to allocate 10% of his portfolio to an unleveraged, inverse index ETF, such as ProShares Short S&P 500 (SH), to provide him some downside protection against a market correction. What if the S&P 500 went on to stage a rally instead -- what if it went up another 25% over the next several months? In that case, the investor's portfolio might be 2.5% lower than it would have been had he not purchased that downside protection. What if, instead, the investor bought the optimal puts to hedge against a greater-than-20% decline in the ETF that tracks the S&P 500, the SPDR S&P 500 (SPY)? As of Wednesday's close, the cost of those optimal puts was 0.86%; if the investor bought enough of those optimal puts to hedge his whole portfolio, their drag on his performance in the event of a 25% market rally would be capped at 0.86%.²

It's worth noting that, in that last case, part of the reason the optimal puts on SPY are so cheap is that volatility is still relatively low. The VIX volatility index closed Wednesday at 15.07, close to its 52-week low of 14.30 (its 52-week high was 48.2). Volatility can spike quite quickly though, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.

Disclosure: I am short TRGL.

¹In that case, Portfolio Armor would round down the number of shares you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with eight of the put option contracts that would slightly over-hedge the 800 shares they cover, so that the total value of your 824 shares would be protected against a greater-than-17% loss.

²For the sake of simplicity there, I ignored the transaction fees of purchasing the ETF and the options, and I ignored the management fee of the ETF.

Mixed Picture

I wanted to first note that I have updated my blog with some helpful information about the US Dollar, Inter-Market Analysis, the Secular Bear market, etc.  It is all worth a look.  You can find it here ... http://facesincabs.blogspot.com.  I am glad that I made the recent move to blogspot, as it allows me to personalize the blog site for my own trading.  You can also find me on Twitter daily.

How Now Dow?

What an odd week.  The intra-day price moves seemed to arrive at the oddest times. I traded pretty well and I grew my main trading account this week (just over 4%) only shorting the markets, but the tape felt rather odd to me.  The rising bond yields (and resulting inflation) kept me from risking too much capital.  I also noticed this week that the $INDU appeared to decline the least of the major indices (see daily chart below).

http://tinyurl.com/3bkapuv ($INDU chart with Raff Regression Channel)

Technically, the middle line of the Raff Regression channel remains a magnet for price, but a rounding top began forming this week (which was posted by Pikertrader on Thursday).  Trend traders may want to continue to buy dips, but I would warn automaton bulls that there are broader signals of a pull back developing on many market internals charts.  I generally see a mixed market picture going forward into April OpEx week, and I would expect price ranges to remain compressed due to the OpEx event.  I would add that the rounding tops developing on many charts this week are much more obvious on the hourly charts, so I am watching them more closely than the daily charts for my own trading.

Other Charts of Interest

Despite some pull backs, the majority of chart structures and trends remain in bulls favor.  I would additionally point out that the greatly weakened $VIX and $USD do not support a bearish move yet.  However, a pull back is developing structurally on many charts, and equity bulls lost control this week to inflation pressures while commodity bulls got a boost from inflation.

http://tinyurl.com/3cav5bq (Transports failed their break out and are in a megaphone pattern)

http://tinyurl.com/3hq5y95 (Small cap's tapped life time highs and pulled back for first time in weeks)

http://tinyurl.com/4thjvfh (Bonds down, but inflation bond caught a bid this week and diverged)

http://tinyurl.com/3njp52l (NYSE Summation Index is closer to unbroken, upper, downward trend line)

http://tinyurl.com/3baze64 (US Dollar makes a lower low, and this is clearly boosting commodities)

http://tinyurl.com/5v3mhl5 (Commodities at higher high, hold up markets, and challenge 62% retrace)

http://tinyurl.com/424jjnr (Real Estate ETF sitting on trend line, and this time looks different)

My gut is telling me something is up with the odd price move by small cap's. I entered and tested a short position in small cap's on Wednesday for a quick swing.  As a result, I am ready to begin trading small cap's again.  I am also watching for follow through on the inflation bets made this last week.

Happy St. Patrick's Day

The oscillators were screaming for a bounce after yesterday's decline, so the markets were weakly gapped up today in front of OpEx Friday.  Personally, I am still trading the shock event pattern (first), then looking to sector rotations and leadership (second), and (third) technicals on the charts.  I mildly day traded today (3 winners / 1 loser).  I would note for those that follow along here that PCLN is looking pretty ripe for daily short entries, as the retail ETF's are finally showing some weakness.  I had a terrific short trade on PCLN today.

Current Determinant Market Relationship

I have mentioned a few times this week about the technical relationships between the Japan and US markets.  After increasingly bad news about the nuclear fallout spreading each day, it is still apparent that this situation is far from over.  I am still watching for another shock down on the NIKKEI (possibly starting tonight). Here are three charts I reviewed a couple of days ago.

http://tinyurl.com/4d3w3h4 (NIKKEI shock event candle will close tonight)

http://tinyurl.com/47rqjxp (NIKKEI decline pressures US bond yields)

http://tinyurl.com/5vps9g2 ($TNX below major 2011 range and support) 

I can still see the NIKKEI technically moving down to 7,000, if a major news event were to shock the markets for another time.  Also, the $TNX remains below 33 and its 2011 primary range - possibly pricing in another move down by the NIKKEI.  The events in Japan have finally given us a different US stock market this week (and that effect is evidently not over).  This is my primary reason for trading the shock event first.

Noise From Rising Oil & Transports

One sector not making new lows yesterday are the transports ($TRAN).  Here is a daily chart, and then below that is a 30 minute intra-day chart showing the active retracement and range of the recent shock event.

http://tinyurl.com/48w7qbs (Dow Theory ... no confirmation, but why?)

Rising oil prices appears to be propping up the transports.  This seems like funny business.  Normally, we would expect rising fuel prices to eat into the bottom line of transporation companies, but that is not happening on the charts.  If oil prices pull back again, then watch the transports for a response.  If the $TRAN can close below 4,900, then this would place downward price pressure on the $INDU, and it might make a 7% correction then.

Update On 7% Declines

• 11,523 - $INDU (No, transports remain somewhat range bound)
• 4,935 - $TRAN (Yes, but did not making lower low with rest of the major indexes)
• 1,250 - $SPX (Yes)
• 2,641 - NASDAQ (Yes)
• 779 - $RUT (Yes)
• 1,055 - $CYC (Absolutely! 1050 has become a pivoting area now)

Based on this information, my take is that we are now entering a correction with the Japan news (day to day) hanging over the markets.  Oil price is currently propping up the transports, the transports have not made a lower low, and so the Dow have not formally corrected yet (the only major index in that category).

OK, I am going to have a beer.  Happy St. Patrick's Day (to those who celebrate that).  You can see my daily tweets here (@facesincabs) and my blog posts will remain stored at  http://facesincabs.typepad.com.

Weekend Review

It was a pretty good week for me personally as a trader.  Since it is the weekend, here are a few weekly charts.  I thought it would be good to review them after the technical damage from this past week on many daily charts.

http://tinyurl.com/5v6qktr ($INDU protected from breaking trend line)

http://tinyurl.com/67d84uk (Small cap's beginning to show relative weakness)

http://tinyurl.com/23bhm3g (Cyclicals holding critical 1050 ... at least so far) 

http://tinyurl.com/4v5wwa6 (NASDAQ 100 still looks like it is heading towards 2250)

http://tinyurl.com/47gcq5q (Banking still underneath major resistance ... leader? nah!)

http://tinyurl.com/6kr4pt9 (Bond yields failed their range break out)

http://tinyurl.com/69mqlgg (Weekly chart of a technically failing tech leader)

After looking at these charts, I would summarize that the weekly chart structures of the major indexes remain intact.  And in closing, I would point out that the GOOG is sitting just above its 200 EMA on its daily chart.  Have a good weekend.

You can see my daily tweets here (@facesincabs) and my blog posts will remain stored at  http://facesincabs.typepad.com.